China's New Leaders’ Embarrassment of Riches

Chinese soldiers marching in front of the Forbidden City in Beijing, China.

New names are the only thing new about China's leadership change. The country's incoming leader Xi Jinping and his cabinet have been carefully groomed and moved up through the ranks of party and government hierarchy on policy agendas they shared and helped create. They are, therefore, no new hands likely to go in unpredictable directions, or to stray from agreed and thoroughly scripted policy paths.

Tasks that lie ahead are much easier than the ones faced by their reform-minded predecessors - starting with the "paramount leader" Deng Xiaoping in 1978. Emerging from the most catastrophic famine in its history, China at that time was still experiencing devastating poverty, hunger, disease and a political dynamite of huge masses of the unemployed in a tiny economy of 364.2 billion yuan ($58.5 billion at current exchange rate).

By comparison - and despite President Hu Jintao's peremptory remarks last November that the Chinese economic growth is "unbalanced, uncoordinated and unsustainable" – the current economic problems look like an embarrassment of riches: the world's second-largest economy of about $8.4 trillion, by far the world's largest foreign currency reserves of $3.3 trillion, one-fifth of world's dollar billionaires and, soon, the world's largest market for luxury automobiles.

That, of course, does not mean that differences in China's regional development, widening income gap, inadequate social welfare system, crippling air and water pollution, unsafe food, growing gender gap, aging population and excessive reliance on exports and infrastructure spending are not serious problems. They certainly are. The outgoing Prime Minister Wen Jiabao spoke at length about all that in the report he presented last Tuesday to the current session of the National People's Congress.

Still, most of these problems can be dealt with fairly straightforward and well-known administrative measures.

But to keep the economy growing at a pace that will facilitate the development of social and urban infrastructure to absorb 400 million of unemployed, and underemployed, rural dwellers and hordes of increasingly restless migrant workers will require a more creative approach.

China is facing two major structural problems in its growth management. The first is the relative weakness of household consumption. The second is the need to open up the capital account, with a flexible exchange rate and a convertible currency. As it happens with most structural issues, the path to a better balanced open economy will lead to China's quasi permanent and wide-ranging structural adjustments.

Getting More Growth From Domestic Demand

The weak consumer spending is a case in point. A meaningful rebalancing of China's current growth composition would entail an increase of the share of household consumption in gross domestic product (GDP) from 37.7 percent at present to at least 60 percent over the coming years.

But to induce Chinese households to spend more by reducing their estimated 25 percent savings rate, Beijing will have to set up a broader and a more generous social welfare system. Families now have to save a large part of their income to pay for medical expenses and education; they also have to save to supplement low pensions and unemployment benefits.

Also, Mr. Xi's objective of "rejuvenating China," and narrowing the gender gap (there are currently 4 percent more men than women), would require a special "family policy" by lifting the "one child" limit and increasing the birthrate through child subsidies, education allowances, widely available and affordable daycare centers, etc.

All that would lead to a better balanced economy because it would boost residential investments and consumer spending.

Can China pay for a better social welfare system?

With a relatively low budget deficit of 1.6 percent of GDP, a strongly growing economy and a public debt-to-GDP ratio of 43.5 percent, China could probably afford to pay a large part of that from general government revenues. But if, as seems likely, most of the financial burden for social welfare were shifted to the corporate sector, non-wage labor costs would rise, leading to increasing production costs, deteriorating competitive positions and layoffs as companies try to keep costs down through productivity gains.

That would hasten an already unfolding process that is spelling the end to China as a low-cost production hub. Large-scale business restructurings, and job losses, would accelerate as Chinese companies are forced to move up the technology curve to produce higher value-added products and services. Authorities would also come under pressure to ease the pain by resisting yuan's appreciation – something that will be increasingly hard to do.

Capital Flows and Yuan Convertibility

It already is. Tight currency management and pervasive capital controls are incompatible with the role played in global finances by the world's second largest economy and a country that last year may have recorded capital exports of $214 billion (the equivalent of China's current account surplus).

Tinkering with bilateral currency swap lines for trade financing, and with limited – and highly controlled – trading in selected asset classes may be useful learning experiences, but that is falling far short of what China needs for its own financial markets. That "hesitation waltz," as the Europeans might say, is obviously showing a lack of policy consensus on how to step forward.

Last week, for example, a high-ranking official of the People's Bank of China (PBOC) is reported to have said that international financial flows were "totally controllable" – a statement sharply at odds with apprehensions expressed by the PBOC's president and the State Administration of Foreign Exchange about loose monetary policies in major economies (U.S., Euro area and Japan) and the big capital inflows raising China's inflation and creating asset bubbles.

It, therefore, seems that the best China can do for itself, and for the rest of the world, is to heed President Hu's demand for a "deepening reform of the financial system."

Otherwise, the Chinese economy may be destabilized and the yuan business could migrate offshore, showing that "totally controllable" cross-border capital flows are just a dangerous illusion. Remember: money is fungible.

And the City of London knows how to take advantage of that. The British Treasury says it intends to "cement London as the Western hub for the fast-growing yuan (renminbi) market." Confirming that "London is growing rapidly as a center for renminbi (yuan) business," the governor of the Bank of England also assures that the "Bank will have the capability to provide renminbi liquidity …."

There is no doubt that opening up China's capital account to financial transactions that befit the world's second largest economy, and the world's biggest capital exporter, will be tough. But that is inevitable and will require smart and creative decisions.

In the process, China's exchange rate will have to become more responsive to changes in monetary and fiscal policies, asset markets and economic fundamentals. That, in turn, is certain to challenge the country's competitive posture, requiring continuous structural adjustments and a more flexible Chinese economy.

Difficult economic reforms lie ahead, but China's stellar track record of economic management inspires optimism, because tougher and more painful reforms have been done in the past 35 years.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia Business School.